Cafe Hayek, meet the Treasury Department

The US Treasury Department on Thursday said it agreed with Abu Dhabi and Singapore on a set of principles for sovereign wealth funds that specifies politics should not influence their decisions.

The foreign-controlled funds, many based in the Middle East, have aroused U.S. lawmakers’ concern because they have poured billions of dollars into large stakes in Wall Street firms and other businesses and fanned fears the U.S. was losing control of its destiny.

…

The Treasury has been pressing since last autumn for the IMF to develop the ”best practices” guide. The funds have become increasingly active in buying U.S. assets with growing foreign exchange reserves from oil and international trade.

And that would be Don Boudreaux of Cafe Hayek – who would most likely remind us of the practicalities of trade: running up monster deficits, needing and attracting capital, one gets the idea.

Mostly I’m just unsympathetic to such boorishness by a system that desperately needs the food, even while it bites the hand providing it. I sure do like to see tribalism weed its way into both international relations and international finance, though.

Oil prices aren’t going anywhere

So while oil prices surge (any doesn’t our media love new words? I look forward to collective MSM embarrassment in a few years, pretending, so 90210, that they themselves, never used it. Or never really liked it, or whatever they think makes them sound cool), it’s worth keeping an eye out for why that trend isn’t going away.

Yes, Peak Oil is a big factor.

Here’s another: oil is an import, from the perspective of the US, and it is bought with the ever-of-less-value US dollar. As long as the dollar loses value, dollar-priced oil will gain it. Hence these manner of stories:

Australia’s central bank increased its benchmark interest rate for the second time in four weeks and said there are signs the highest borrowing costs in 12 years are prompting consumers and companies to temper spending.

Governor Glenn Stevens and his board raised the overnight cash rate target by a quarter point to 7.25 percent in Sydney today to stem the fastest inflation since 1991. Stevens said rates have risen “substantially” since mid-2007.

The nation’s currency dropped and bonds rose as investors bet the central bank may not raise rates again in the next 12 months. The 1 percentage point increase in the benchmark since August contrasts with the U.S., Canada and the U.K., which have cut rates to cushion their economies from slower global growth and credit-market turmoil.

Yes, a full percentage point. We had our sixth rate increase in 3 years during the election campaign, and this is the second again since thing – the commodities boom is simply very strong. Nor are we alone in our willingness to face inflation. More relevantly, though, capital is moving away from low-interest-rate US to other currencies (Euro, Yen – I certainly don’t imagine it’s all heading to Australia), and operating currencies (NGOs, multinationals, small governments) are probably quietly diversifying, removing an old source of over-value for the US dollar.

All of this means that the prices of things that are typically priced in US dollars are going to appreciate. E.g. Gold (’cause it’s easier to find):

Flattening it out:

We still see the US Dollar prices moving from the Euro price up towards the AUD price. Why? Well, see the price of the US dollar:

What do you think that will do to the percentage changes in price, USD, EUR and AUD? Exactly. Again, gold (or oil) is appreciating in price, but moreso when that price is denominated in a sinking currency.

Key Economic Developments and Prospects in the Asia-Pacific Region 2008

By now the report by the United Nations’ Economic and Social Commission for Asia and the Pacific (UNESCAP) has made the news, mostly through its pessimism regarding the US economy – but it has far more within! You can read the entire report here.

Specifically, and as per the IHT link above, it mentions the growth rates of Asian economies (the “AP” in ESCAP):

Eco 1 students! This returns us to the principle of Catch-Up:

Short version: emerging/developing economies, assuming that they have adequate policies in place, will exhibit higher rates of economic growth than developed countries, eventually “catching up”. Compare, in Table 1 of the UN ESCAP report above, the developing/developed economies numbers. That is catch-up. It is also why the bourses of emerging markets will usually out-perform those of developed exchanges.

Another section of interest in the report is Sovereign Wealth Funds, to wit:

Buoyant reserve accumulation by countries in the region is adding to the stock of capital for existing wealth funds. Reserves are increasingly being accumulated not for prudence in times of crisis but as a result of managing currency appreciation. Therefore, there is no limit to the level of reserve accumulation.

It has become increasingly important for Governments to consider setting up sovereign funds as a strategy to obtain a reasonable level of return on their burgeoning capital. In addition, such funds serve to reduce risk by diversifying the assets in which foreign reserves are invested. Existing sovereign funds are also allocating more of their capital to riskier assets. For instance, the Russian Federation uses its stabilization fund partly to meet emergency budget shortfalls and partly for investment purposes.

Sovereign wealth funds have a major potential impact on movements in international financial markets. The volume of capital under their management is at least twice as much as that of hedge funds. Estimates put the current size of the world’s 25 sovereign funds at about $2.5 trillion, with a rise of $450 billion in 2007. It has been forecast that the resources at the disposal of sovereign funds could rise to $12 trillion by 2015. The region’s major established funds are the Government Investment Corporation of Singapore, with holdings of $330 billion; the stabilization fund of the Russian Federation, with assets of about $100 billion; and the Investment Agency of Brunei Darussalam with $30 billion. The Republic of Korea also began its own fund, the Korea Investment Corporation, in 2006 with capital of $20 billion.

The desire to obtain healthy returns on their bulging reserves is also leading other countries in the region to consider setting up their own wealth funds. The year 2007 saw the formation by China of a sovereign wealth fund to invest $200 billion of its foreign reserves in other investments. Investments by the country’s new State Foreign Exchange Investment Corporation will be in financial and strategic assets around the world.

Sovereign wealth funds present a number of challenges for their owners. One is that they are prone to protectionist sentiment from investment-receiving countries because the funds are government entities. In this context, the extent to which investment in a company by a sovereign wealth fund results in voting rights or management control is important. A reasonable amount of information on the investment strategy and portfolio holdings of sovereign wealth funds would also help to reduce concerns from investment-receiving countries.

Currently, most funds are opaque about internal checks and balances, investment strategy and commercial goals.

Surprisingly (for me) was the extent to which the Russian Federation had expanded its holdings of foreign reserves, in 2007:

Although that could just mean I’ve been here too long (I’m forever trying to argue with colleagues here in the US about the latent strength of Russia. The mindset here is that they were soundly defeated and will never be a problem – very English thinking on the issue, frankly).

The report’s discussion of inflation (pinning no small amount of the same on the Money Supplies in Asian and Pacific economies) is very good also. The report is well worth the time of students of economics to read.

Currency downsizing: evolution or devolution, question-mark

Following-up the long-running tale of sovereign currencies – first this excellent piece in Foreign Affairs, months ago now, then this more recent catch-up with the mooted Gulf Common Currency (for the Gulf Common Market) – Latin America is in on the game:

Ecuador’s President Rafael Correa wants Latin American countries to merge repatriated offshore assets in a fund that would back a proposed regional currency.

Correa, with five other South American leaders, on Dec. 9 signed off on a joint development bank, the Bank of the South, promoted by Venezuelan President Hugo Chavez to counter the influence of institutions like the International Monetary Fund and the World Bank.

“The Bank of the South is an important step but the next step is missing, to create a Fund of the South, a fund that will bring back all those funds that Latin America, particularly South America, holds outside its borders, close to $250 billion, to serve as a backing in the case of financial and balance of payments crises,” said Correa today in his weekly radio address.

The fund could be used to support countries in the event of crises, its returns could be used to fund investments in infrastructure, and its assets could serve to back a regional currency from Mexico to Patagonia, he added.

Rather than booking transactions in U.S. dollars, the countries in the region could use a transaction unit backed by such a fund. “That’s the first step to later have a currency, the latino,” said Correa.

…

Correa, the 44-year-old economist who studied in Belgium and the U.S., has been one of the most vocal supporters of a unified Latin American or South American currency.

I can’t work out whether this counts as devolution of sovereign currency or evolution. On the one hand it marks the evolution of sovereignty into higher levels of aggregation and representation; on the other, Big Trades are ever-more likely, “going forward”, to involve multiple potential currency bases – devolution – rather than just the US dollar.

I consider both moves to be good ones: the predominance of the US dollar in international transactions – oil, weapons, aid – confers upon the US (and, prior to them, the British) a political predominance that may or may not be either deserving or desired. For the US, specifically, this predominance keeps their currency over-valued, making the risk of precisely what is happening at the moment a carried one through time.

I look forward to seeing, for example, this comparison of the S&P internationally being repeated in a year, once people are done fleeing Wall Street for Emerging and Other Markets.

Meanwhile, as such moves as these pick up both speed, sincerity and credibility (since a lot of this can be laughed off as anti-IMF posturing – although I don’t believe it should), we will probably observe the slow re-valuation (in our own minds, as well as on our exchanges) of the US dollar, the slow boost to the Euro and the Yen (since people need somewhere to go, while we wait for these regional currencies to present themselves), and who knows? Possibly some mature regional co-operation in other parts of the world, as a reaction.

“A day after the Federal Reserve disappointed investors with a modest cut in interest rates…”

Was there anything so ridiculous as the petulance of Jim Cramer’s wall street?

A day after the Federal Reserve disappointed investors with a modest cut in interest rates, central banks in North America and Europe on Wednesday announced the most aggressive infusion of capital into the banking system since the terrorist attacks of September 2001.

Most market specialists and economists welcomed the effort but concluded that it would probably have only limited success in addressing broader problems in the global economy and the credit markets.

In response, stocks initially surged in New York, but most of the early gains dissipated in afternoon trading as the market moved wildly up and down through the day.

Over at the blog The Big Picture:

We continue to discuss the technical aspects of the Dow action in the office. There is a divergence of informed opinions, ranging from “Breakout over 1500 SPX was bullish” to “Let’s wait and see” to “a major top is forming.”

…

The strong opening gap yesterday, followed by a near 400 point reversal, only to close marginally higher is, in my opinion, simply awful technical action.

It was concisely put over at the Wall Street Journal (linked out-to at the Big Picture):

A day of exceptionally volatile gyrations in stocks left traders exhausted, and showed how nervous investors still are about the market’s prospects.

Finally, Eco 1 students: I’ve mentioned, several times now, the over-investment that drove a lot of the dot-com-busted recession earlier in the decade. In the same post, the Big Picture carries an excellent illustration of (a) precisely that and (b) why the current threats to jump out of Blue Chip Windows is pure glutton’s melodrama.

China/US: now the upper hand is on the other foot

Score one for my prescience! Except my hypothetical involved OPEC, not China. Still. Close.

Beijing turned the tables on the US on Wednesday after years of criticism from Washington of its handling of the Chinese economy, warning of the serious global implications of the weak dollar, recent US interest rate cuts and the subprime crisis.

Beijing highlighted US economic problems at the opening of a twice-yearly meeting between ministers from both countries,

China has received stringent commentary about what many in the US say is its manipulation of its currency and the advantage it gives local exporters.

Chen Deming, the incoming commerce minister, said the falling dollar had pushed up the cost of imported resources and been a destabilising factor. “What I’m worrying about is the weakening dollar and its potential impact on global growth,” he said.

… Mr Zhou said the bank was closely watching the impact of US interest rate cuts and their impact on the world economy.

“For China, what we worry about more is that very accommodative US monetary policy could give rise to a new burst of excess liquidity in global markets,” he said.

“In China, we have already had an excess liquidity problem in the domestic market, which we know is somewhat connected to the global markets.”

Rather a slap in the face for their guest, Secretary Paulson. His reponse?

Mr Paulson did not respond directly to the criticism but said the fact the Chinese economy had grown strongly through the early stages of renminbi reform had made it “easier to make the argument” for a stronger Chinese currency.

“There is now confidence that the [revaluation] has not done anything to harm their economy in any way,” he added.

“Easier to make the argument”? Paulson has done nothing about the weak US dollar except travel the globe talking about a strong dollar and how great the US economy is (oh, with that stop-over back home to try freezing mortgage rates for a surgically-identified sub-set of victims of sup-prime mortgages). I don’t think people are going to listen to the man who does that. It’s like having Tony Snow as the bloody Treasury Secretary.

Dirty floats, (III)

Following Dirty Floats I and Dirty Floats II, comes Brazil’s latest move into the Club For Carriers Of Big Sticks.

Brazil will create a sovereign wealth fund with the primary aim of intervening in foreign exchange markets to counter the appreciation of Brazil’s currency, according to Guido Mantega, finance minister.

“It will have the function of reducing the offer of dollars in the market and helping the real to appreciate less,” he told the Financial Times.

Honestly. Give some people a barely-accessible-maybe-superfield and they think they can do anything. The full transcript of the interview here. Some interesting views on taxation and tax reform, at least. Back to the sovereign wealth fund:

FT: What about the sovereign wealth fund that you announced in October. How are plans progressing?

MR MANTEGA: This is a normal reaction of a country accumulating foreign reserves, giving it greater fire power in its international reserves. All countries accumulate reserves and this is nothing different from what other countries do.

What we want to do is something very modest. Our reserves will soon reach $180bn. Along side the reserves we will create a fund to buy dollars in the market. It will be defined by law, it doesn’t exist yet so it needs new laws. It will have a limit of say $8bn, $10bn to be accumulated over time. Today it is the central bank that buys dollars. In future we will have the fund also buying. It will have the same function as our reserves, to take out excess liquidity of dollars that cause the currency to appreciate. So it will have the same function as central bank intervention in foreign exchange markets.

…

FT: Aren’t sovereign wealth funds usually created by countries with surplus income either from government-controlled exporters or from other budget surpluses? That isn’t the case in Brazil.

In oil exporting countries with sovereign wealth funds, either the exporting companies are public, so their revenue is primary income, or the countries charge a tariff, which is also primary income. That is one model. Other countries, for example India, aren’t like that. It has a nominal budget surplus and reserves. So our primary budget surplus is identical to having reserves, it is equal to our reserves.

I do believe he will find that opinions differ, on a few of those points (and others, such as using the fund to enhance capitalisation/liquidity for Brazilian firms when they try to make plays overseas).

Why worry? Besides the fact that Sovereign Wealth Funds are just plain dodgy; this one in particular plays at managing the erstwhile floating exchange rate of the Real (this is not unusual: a “dirty” float is a managed-within-certain-parameters floating exchange rate. Bobbing exchange rate, if you like: not allowed to go too far in any direction), but not in the manner of the erstwhile independent Central Bank.

This means, naturally, that the management of the float need not be undertaken solely according to the relatively benign criteria of price/money stability. With his talk of aiding Petrobas, in fact, Mantega has signalled precisely the opposite.

The fund will also, it seems, encroach actively upon the Central Bank. Back at the interview:

… our primary budget surplus is identical to having reserves, it is equal to our reserves.

Our reserves will continue to rise. Every day there are excess dollars in the market. Every day the central bank buys a billion or half a billion dollars and puts them in the reserves. With the sovereign wealth fund we will have another agent doing currency auctions and buying dollars. So instead of the central bank buying a billion, like yesterday, the central bank will buy half a billion and the fund will buy the other half.

So now the Central Bank, formerly able to buy dollars independently of the government, can now only do so half as much. The other half is managed out of the Treasury.

This basically reads, in toto, as a fairly structurally deliberate move away from Central Bank independence (or further away: I don’t really know how Brazil rates). Just imagine the US, UK, etc. equivalent, though. The US Treasury department taking over half of the reserves with which the Federal Reserve manages the US dollar (hypothetically. Supposing somebody managed it). I’m assuming – hopefully correctly – that we’d hit the damn roof.

What’s USD30bn to China, anyway?

More finance. I need to get back to something Environmental, or cars, or something.

China is to treble the amount of money that foreigners can invest in the mainland capital market, making the long-awaited announcement on the eve of this week’s high-level economic summit between Chinese and US policymakers.

The State Administration of Foreign Exchange, the country’s foreign exchange regulator, said on its website on Sunday that the quota for registered foreign investors would be increased from $10bn to $30bn. It could take several months before institutional investors secure fresh quotas.

Good for openness in foreign capital movement – don’t get me wrong – but before we get too carried away, don’t forget how much capital going out: that USD30bn compares with a few hundred billion US dollars in Sovereign Wealth Fund money, not to mention new, looser, rules for their total capital outflow.

Baby steps are still steps, of course.

Contractionary Monetary policy, China, Paulson, trade deficits…

It’s almost a shame I’m done writing the final exam. Actually I’m not — I can’t get it printed until Monday morning — but it’s probably too long already. The last thing I need is another question in there.

China ordered banks to increase reserves by the most in four years to try to prevent the world’s fastest-growing major economy from overheating.

Lenders must put aside 14.5 percent of deposits as reserves, starting Dec. 25, up from the previous 13.5 percent, the People’s Bank of China said today on its Web site. The ratio is the highest since at least 1987 when the data began and the increase is twice as much as the nine others this year.

Impressive. Bloomberg (the wire service) seems to pin a lot of it on Paulson, though:

The decision comes before a visit to Beijing next week by U.S. Treasury Secretary Henry Paulson, who said Dec. 5 that China’s government should allow the yuan to appreciate at a faster pace to reduce the nation’s record trade surplus.

…

Paulson has argued a stronger yuan would slow the expansion of China’s trade surplus and reduce tension with international trading partners.

“A more flexible currency is especially important now, when the risks of inflation are clearly rising,” Paulson said in a speech in Washington this week.

a) Paulson should be more concerned about his domestic economy than his economy’s balance of payments or terms of trade (I think); (b) exports hire too many people: China clearly would rather deal with this on a slowly, slowly basis — something Paulson could call up Bernanke to have explained. If he’s not too busy dealing with that investigation in Goldman’s CMO shenanigans; and, finally, (c) could we/the US please accept that the demand side of Problems International are usually those to be addressed? China does not have to respond to the fact that we can’t compete, level playing field or not.

We aren’t exactly apologising to every poor bastard we’ve dragged through the Appellate court of the WTO, while dumping our goods in their markets. Nor do we apologise to the poor bastards we put out of business with our food aid.

Bloomberg, meanwhile, seems to be over-selling Paulson’s influence. I would suggest that the strongest correlation with this move is those nine previous increases, rather than Hank Paulson. We can all agree — put them to one side, and I reckon most knowledge Chinese officials would, too — that currency appreciation, rather than Required Reserve Ratio appreciation in the face 18% Money Supply growth, would do more to slow inflation. The choice is whether to slow Bank profitability, or put exporters out of business. The US can move softly, softly and hope for the best — why can’t everyone else?

I shall be interested to see how exposed to foreign capital China is: Australia, for example, is an exposed economy wherein, upon trying to lower the Money Supply to increase Interest Rates to lower Investment to lower Aggregate Demand to lower Inflation, the influx of foreign cash in response to said rate increases had a positive effect on Investment, un-doing the work, but also lowering Net Exports, thanks to currency appreciation (no, I do not like speculators). In that vein, Secretary Paulson could, perhaps, take the time to talk to, say, Goldman Sachs, UBS, Credit Suisse and Morgan Stanley:

Credit Suisse and Morgan Stanley have each signed agreements with Chinese partners to establish mainland investment banking joint ventures.

The deals signal that Beijing is poised to relax a two-year ban on foreign investment in the country’s securities industry.

Only Goldman Sachs and UBS won approvals before China stopped such deals, fearing that overseas companies would dominate the industry.

The inability of most foreign groups to underwrite mainland IPOs or trade domestic securities has proved costly with the stock market booming and A-share listings in Shanghai and Shenzhen raising $60bn this year.

By way of points of reference, the percentage point increase in China’s Required Reserve Ratio is expected to remove around USD51bn from the economy (the economy that made USD470bn or so in loans, this year).

Alternatively, here is a thought-experiment: rather than taking care of their own interests, suppose the finance ministries of the OPEC countries (Arab and otherwise) started actively touring the world, lecturing everyone on how the US should do something about its depreciating currency and record levels of debt.

Revaluing the Riyal

Gulf states, including Saudi Arabia and the United Arab Emirates, may revalue their currencies while maintaining their pegs to the U.S. dollar, a person familiar with Saudi monetary policy said.The states may revalue by an unspecified amount in as soon as a month’s time, the person, who declined to be identified because the matter is confidential, said yesterday. No decision has been made on whether to revalue, he said.

Constistency between exchange rates is driven by arbitrage. Suppose USD1 = EUR1.4, USD1 = AUD0.85 and EUR1 = AUD0.65. What happens? People will use their US dollars to buy Australian dollars, use those to buy Euro, use those to buy US dollars and end up with more money than they started.

If USD1 = EUR1.4, and USD1 = AUD0.85, then, strictly speaking, EUR1 = 0.85 x 1.4 = 0.61 (ish). So If I start with USD100, I get AUD117.64. With AUD117.64, I get EUR76.47 and, with that, I get USD105.05.

What happened? EUR1 = AUD.61, if the other two exchange rates are to hold. As long as this disparity exists, I’ll make money. Within about, say, 40 seconds of trading opening, however, the price of Australian dollars, in terms of the Euro, will go down – because everyone will be in on this. So EUR1 = AUD.61 almost immediately.

Why is this relevant? The Riyal (amongst other OPEC currencies, but let’s simplify our analysis and do something very economist-y, like assume there’s only one oil-producing country, and that country has pegged its exchange rate to the dollar) is ‘pegged’ to the US dollar. This means there is a limited range within which the Saudi government lets it vary (the target is USD1 = RIY3.5). I.e. the Riyal will buy, in US dollars:

However, and as we know, the US dollar hasn’t been doing so well. Now we’ll extend our model to 3 countries: Saudi Arabia, the United States, and the EU. So the US will buy, in terms of Euro:

It’s not that big a deal: we could ditch them and just use Gold, without too much trouble. So: how many Euros, d’you think a Riyal will get you, lately?

Exactly. Now, suppose our Saudia Arabia facsimile doesn’t, say make much of its own ‘stuff’, but imports it. Practically all of it, paying with money it makes from exporting petroleum. Suppose it’s importing all of these goods and services from, say, Europe. Based on the chart above, what should happen?

Record levels of inflation. Nearly 5% last year: 9.3% in the UAE, and nearly 15% in Qatar. Meanwhile, income is steady, as oil is sold in dollars (although the price has been increasing – one can begin to see the advantage.

Which brings us to the story: a potential revaluation of the Riyal and other affected currencies. Still, it seems, a pegged exchange rate (although, with Saudi Arabia – and others – not following Bernanke’s second rate cut recently, it looked like they were going to accept a broader wobble in the peg, in order to buy at least a little slack with which to try and deal with inflation). The talk:

“It makes sense for them to do it,” said Jens Nordvig, senior global markets economist at Goldman Sachs Group Inc. in New York, in a phone interview. “Given the emerging inflation pressures, there are very good reasons for them to allow currency appreciation.”

…

“It’s unlikely they are going to move to a flexible system,” Nordvig said. “If they’re going to make an adjustment, they should make one that matters. Something in the 5 to 10 percent range seems like a range that would have some impact without being overly dramatic.”

That’s cool. If, in our over-simplified model, inflation is pulling 5%, and the Saudis revalued their currency 5%, they take a hit on their revenues – something amenable when oil’s spot price is marching onwards like a Christian bloody soldier – and ‘fix’ imported inflation that has landed on them thanks to the US economy (thanks, of course, also to their insistence on a pegged exchange rate, but that’s their prerogative too, I suppose). So, back at that first chart, we can see the market reacting already (Bernanke, Paulson: this is credibility); people are trying to get in on that arbitrage game: buy Riyals now, and make 5 to 10 percent (possibly?) on them in a month’s time.

What does that mean for the rest of us, though? There hasn’t been as much of a change. The Riyal only buys slightly more Australian dollars, for example:

I’m too lazy to look too broadly, but it looks like the big gamble is with US dollars (and why not, if they’re still expected to depreciate farther – don’t forget, the markets have also ignored Bernanke’s warning). It has bumped against the pound sterling, as well – but, again, not like it has against the dollar.

For “us”, the newly introduced 4th country (since I don’t care overmuch about Europe), this will have an impact on our exports to these countries – principally wheat, from what I’m aware. According to the CIA world factbook, though, we don’t even rate:

US 12.3%, Germany 8.6%, China 8%, Japan 7.3%, UK 4.9%, Italy 4.8%, South Korea 4.1% (2006)

We exchange one or two billion Australian dollars’ worth of stuff. So. Not a big deal, at least for them. We also send a fair amount (from our perspective) to the UAE, Qatar (famously, formerly, Iraq). We aren’t really relying upon our exports to keep our economy up, so it shouldn’t have too great an effect. Since these countries principally only export petroleum, they shouldn’t actively be generating inflationary pressure for us (or at least not moreso than our own demand). I would be interested, though, in what may happen with Germany, the US and Japan. Economies that are wobbly (or wobbled, in the case of the US), and more dependent on exporter earnings.

I shall follow this up sometime with more work looking at their exposure to the rest of the OPEC countries that are – according to these person familiar – considering the revaluation. Perhaps it could have a significant affect on their economies.